Tepper’s fundamental and valuation concerns are really just manifestations of our current late-cycle reality and a recapitulation of our 2Q15 #LateCycle Macro Theme.

We don’t always agree with Tepper but, when we do, we like to do it 3-months and 150 SPX handles ago.

(The prescient cartoon above was published one year ago this month.)

Back to the Global Macro Grind…

Since 2 & 20 sourced soundbites still grab more headlines than Hedgeye’s #BlueCollarMacro mouthpiece, Tepper’s comments yesterday offer a worthwhile opportunity to review some of the fundamental market data and contextualize the current expansion within the historical late-cycle experience.

First, The Cycle: Let’s take a quick step back to re-remember the archetypical economic cycle – from the perspective of the current cadre of policy makers.

Macro cycles, left to themselves, follow a pattern that largely resembles the circular, counter-clockwise flow captured in the inflation-output loop depicted in the 1stChart of the Day below.

The conventional view is that the level of output drives inflation which, in turn, drives the policy response. These output-inflation cycles were the prevailing macro reality when the present global policy making oligopoly was coming of age and conventional monetary policy is designed to function within the context of this naturally evolving cycle.

The broader goal of current policy efforts is to both jump-start and subsequently smooth such a cycle in the face of persistent cyclical challenges and glacial secular shiftings.

Policy = Lost in Transmission

The Phillips Curve and the aforementioned output-inflation cycle on which conventional monetary policy is based has been so loose over the last 2 cycles (& the present one) as to be non-existent.

Meanwhile, the empirics on Janet’s hoped for policy flow through to Main Street remain dismal. Labor’s Share of National Income – which, historically, only rises at the tail end of an expansion and after growth and profits have been strong for a protracted period – remains at a multi-decade trough. Even if we follow the pattern of gains in the late innings of expansion it won’t close the gap – and, if it does, it will likely come alongside a step function move lower in corporate profitability and EPS growth.

The other side of rising inequality and top-heavy income distributions is lower highs and lower lows for labor income.

Valuation = An Anchor, Not a catalyst

Valuation is not a catalyst and from a short-to-medium term risk management perspective, it sits somewhere near the middle-bottom of our consideration hierarchy.

That said, over the longer-term, valuation certainly matters in anchoring return expectations and we don’t discount it as a factor completely, particularly as it moves towards extremes in either direction. Underneath the technicals, acute policy catalysts, and reflexivity that drives immediate and intermediate term price trends sits the steady drumbeat of fundamentals and an accordion-like tether to ‘fair value’.

Because investor’s maintain varying proclivities for particular multiples and conceptual valuation frameworks, one measure we track is a valuation composite which represents an equal weighted composite of three of the most widely used conventional valuation metrics: Shiller PE, SPX Market Cap-to-GDP and Tobin’s Q.

We review each in turn below but the broader conclusion is straightforward: current valuations are richer than at any point except the nose-bleed tech bubble highs. As we’ve highlighted, lower neutral policy rates and perma central bank interventionism may indeed be supportive of higher mean valuations but that only modestly dilutes the conclusion. When valuations are in the top decile of LT historical averages, subsequent returns over medium and longer-term periods are just not that compelling.

Shiller PE: Inclusive of the hundred’s of billions of market cap lost in the recent correction, the Shiller PE remains above 24x and sits just south of the top decile of its historical range. Mapping the Shiller PE by decile vs subsequent market performance suggests return expectations should move systematically lower alongside incremental increases in valuation. Historically, 1Y and 3Y returns progressively decline for each decile change in the Shiller PE.

Tobin’s Q: Longer-term valuation arguments center on the premise that returns on capital should equalize to cost of capital and market values should normalize to economic value. Tobin’s Q ratio is not a measure we use to tactically manage risk, but we can appreciate the intuition underneath its application – why buy an asset when you can re-create it for less and compete away existing, excess profit. Historically, at extremes, it has served as a solid lead signal for subsequent market performance. Currently, the q-ratio sits at ~1.06 and greater than 1.3 standard deviations above the long-term mean value – a level that has generally not been a harbinger of positive forward returns historically.

S&P 500 Market Cap-to-GDP: Assuming the collective output of SPX constituents credibly reflects aggregate national production (or serves as a credible proxy for it), the Market Capitalization-to-GDP ratio effectively represents a price-to-sales multiple for the economy. At current levels we are well above both the LT average and the 2007 highs.

The Chart of the Day below shows the valuation composite using the most recent data for the respective metrics.

PEAK PROFITABILITY

Earnings, Corporate Margins and collective SPX profitability all peak mid-to-late-cycle and the last few quarters of data suggest we’re probably past peak in the current cycle (ping sales@hedgeye if you’d like to review our 2Q/3Q Macro Themes decks).

In a low-to-no growth environment where the pie size stays the same, peak margins are good until they aren’t and are probably a symptom of policy ineffectiveness (in terms of flow thought to Main St.) more than not. Unless you think peak returns to capital provide a sustainable path to aggregate demand growth in the face of negative trend growth in real earnings, trough returns to labor, middling productivity growth and secularly depressed investment spending, then the mean reversion risk for operating margins remains asymmetrically to the downside.

2Q15: As Keith highlighted yesterday, with 2Q earning largely rearview for SPX constituents, the final score shows revenues and earnings down -3.5% and -2.2% year-over-year, respectively. Yes, the commodity rout was an outsized impact to energy/industrial’s profitability and this year’s collapse becomes next year’s comp but still, negative top & bottom line growth is not the stuff escape velocity, private-sector handoffs are made of or multi-year tightening cycles anchored on.

Today is Patriot Day. To those who serve(d) in the military and those, more broadly, who go underpaid and underappreciated in service of our greater good, your selflessness does not go unnoticed and your sacrifice will not be forgotten. We are sincerely grateful for your effort.

To hope & humanism, doing the right thing when no one is looking and blue collar alpha,

Christian B. Drake

U.S. Macro Analyst

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09/11/15 08:13 AM EDT

The Macro Show Replay | September 11, 2015

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09/11/15 07:54 AM EDT

September 11, 2015

BULLISH TRENDS

BEARISH TRENDS

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REPLAY | GOING LONG UNFI BLACK BOOK TODAY @ 11AM ET

As we stated a few weeks ago in a note, we added UNFI to our LONG bench (NOTE HERE). Now, after doing more work we are very confident in the longevity of this company and as a result are upgrading it to a LONG. UNFI has been battered down this year by ~35% due to significant worries stemming from the loss of the Albertsons contract as well as the competitive landscape. Although increased competition (KeHE) and the potential of the captive systems are some of the biggest risks, we feel that this loss is an isolated incident and the company should not be penalized to this extent.

On August 20th, UNFI pre-announced 4Q15 and FY16 outlook and provided some positive color about the future for UNFI. Management provided positive commentary about the performance in the first two weeks of 1Q16, although only two weeks, it’s a marked sequential improvement and suggests that the core business remains strong. Following the loss of the Albertsons contract, the notion that UNFI will continue to lose customers is overblown and not very realistic in our minds. UNFI provides a value added proposition (a high level service to retailers), offering a wide variety of over 80,000 products at industry leading prices. The industry is seeing continued growth in natural & organic, specialty, ethnic gourmet and fresh, all of which UNFI offers and can package together to provide retailers great value.

Following the disappointing end to FY15 UNFI is in a great position to leverage the strong asset base it has built. Over the past two years, UNFI has gone through a period of significant investment in capacity to take advantage of the growth in the fresh, natural and organic market place. With this investment in the past, capex will be declining to more modest levels, about 0.6% - 0.7% of net sales. As a result, free cash flow is going to start to ramp up significantly and coupled with an underleveraged balance sheet M&A will become a bigger part of the story going forward.

RH | Growth = On

Takeaway:This story is inflecting. Now. Growth in revenue/margins accelerates meaningfully in 2H. So should the multiple and stock. Headed to $300.

This was a textbook print from RH – or for any company, for that matter. RH put up the best comp in all of US retail this quarter with 16% brand comp and 19% store comp. That drove 26% EBIT growth and 27% EPS growth. RH beat by a penny, but took up the lower end of the year by $0.03 more than the 2Q beat. That upside is coming entirely in the fourth quarter, and as we suspected (see below) this all allowed RH to set the bar low for 3Q as revenue from new businesses will not be booked until 3Q closes in October. We think all of this sets up for a beat in another 90 days, at the same time square footage growth is accelerating to 29% vs 7% in 2Q, new concepts (RH Modern/RH Teen) are in full swing, and EPS is growing 40%+. This is going to be a rough time for the bears – especially with 25% of the float short.

Transformational stories like RH are not linear, and this one certainly has not been. The stock chart over three years certainly proves that. But it also proves that the people who bought on quarterly noise have made money almost without fail. If the market decides to sell off based on lower guidance in 3Q (i.e. if the after-market gains reverse), then consider it a gift. Fundamentally and financially, we’re about to see growth at RH go on a multi-year tear. We think this stock is headed to $300 over the next 2-3 years. We’ve been patient for the catalyst calendar to begin, and the waiting is finally over.

For a full rundown of our thesis see our latest Black Book published in July.

Takeaway: We’re confident in RH across durations. But when asked about the ‘worst that could [realistically] happen’ on Thurs, here’s our answer.

We think that the core long-term call on RH is as clear as ever, as is the catalyst calendar over the next six months. We outlined all of this in our two recent Black Books 1) Road to $300 (Link: CLICK HERE), 2) Home Furnishings Deep Dive (Link: CLICK HERE).We also think that the numbers RH will report on Thursday will be spot-on with the type of model we expect to see from RH going forward (comp 14%, Revenue 18%, EBIT growth 25%, Cash Flow 30%+).

But yesterday someone asked us…

Q: “What’s the worst we could hear from RH on Thursday”?

Our answer sounded something like this (actually it sounded exactly like this)...

A: “We’re not worried about the print. RH has never missed a quarter and it’s not going to start now. This will be one of the lighter quarters of the year, and earnings should STILL grow 25-30%. If there’s any bad news, it will likely come in the 3Q comp guide – with earnings potentially shifting into 4Q. There are some legitimate factors that could cause a lull in the top line, and whether or not they materialize, our bet is that the company invokes them to keep expectations grounded.“

Let’s put ‘light guidance’ into perspective. We think that a worst case comp guide is in the high-single digits (we think less than 30% probability). That would leverage to revenue growth in the low dd, and EBIT/EPS 30%+ (the consensus is at 37%). If the worst case scenario were to happen, we’d have to give the revenue/earnings to the fourth quarter. In other words, the year really does not change materially. Also keep in mind that there is little upside baked into the guidance in 2H from the new categories which already calls for the underlying growth rate to accelerate by 350bps. It’s also worth noting that the company would have to guide 3Q comps as low as 5% in order for the 2-year trend to turn down. We put less than a 5% chance on that happening.

What would cause 3Q guidance be light? There are three meaningful business drivers in 2H that move the needle.

Chicago (62,000 feet in the most elite part of Chicago’s Gold Coast -- but at a non-elite cost).

Denver (another anchor property -- using 53,000 feet of the 90,000 left vacant by Saks at Cherry Creek).

Tampa (47,000 feet, which is spot on with what our real estate analysis suggests is appropriate for 10% market share and $1,200/ft).

Austin (47,000 feet at The Domain – likely to replace one of the two small-format stores in the area, one is just 4-miles away. That makes sense given that our math suggests that Austin could support 50-60k feet for RH).

Here’s why timing matters.

1) Delivery, Not Order = $. It will take a six months to build mass awareness for the new concepts, but RH should begin to take customer orders at a level that actually matters within 3-4 weeks of launch. Let’s say $50mm combined for both concepts right off the bat. We’re talking about roughly 8 to 9 points of comp in the quarter, which would be an extremely solid start. But the problem is that even if the orders are placed for both concepts by October 1, then we need to count forward by at least six weeks for revenue recognition, as customers only pay for product upon final receipt. That puts the sales into mid-November, which is the first month of the fourth quarter.

2) Ditto for store openings. Chicago and Denver are likely the only stores to impact square footage count for 3Q, but only around 5% of revenue is ‘cash and carry’, meaning that the consumer walks out with the purchase on the same day. The rest of the revenue builds into the fourth quarter P&L.

3) RH Cleared The Deck. In anticipation of its new concepts and stores, RH explicitly noted on the last call and on the recent convert Roadshow that there would be a lull in the summer as it relates to new product. That has, in fact, shown up in the online data that we track for RH, as visits to the site seem to have fallen behind last year for the better part of eight weeks. This week’s reading shows that RH is back on par with last year, and we expect that to head meaningfully higher throughout the third quarter. But again, there’s a good 6-8 week lag between the pick-up in business that we see vs. when RH actually sees it on the P&L.

One other reason why RH might guide lightly. Simply put, because it can. It has never had such a position of strength, yet the shorts are already betting against RH with 25% of the float held short. It has two major initiatives that are stand-alone multi-year growth platforms, and we wouldn’t be surprised to see another announced by the time the year is done. Add up the four stores being added this year and we’re looking at about 210k square feet. That alone represents about 25% growth in square footage (and that’s not counting Atlanta). Keep in mind that this company went from over 100 stores pre-recession (and before having a defendable merchandise, real estate strategy, and actual management team) to 67 in the latest quarter as it culled bad locations. Square footage grew on occasion over that period in a given quarter, but has settled in around 850k. Starting in 3Q, we should see square footage growth ramp from a mid-single digit rate in 2Q to a number ~20%, then steadily march towards 35%+ in FY16. Then we’ve got 20%+ square footage growth every year thereafter for at least five years based on our real estate analysis.

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09/10/15 04:03 PM EDT

Cartoon of the Day: May The Farce Be With You

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